I’ve run into some confusion lately on FinTwit with respect to ‘currency swap basis’ and ‘currency swap rate’. The discussion was about changes in currency hedging costs for euro and yen-denominated investors buying US fixed income assets. Admittedly, it’s easy for people who aren’t deep global fixed income practitioners to confuse them. I thought this simple description might help.
A currency swap is supposed to reflect the interest rate differentials between two countries. But it never works out to exactly that. There’s usually a small difference. And that difference is called the ‘basis’. ‘Deviation from theoretical’ is how I think about it. So, the basis is not the cost of the hedge, but it is one component of the overall swap rate, which is the cost of the hedge.
The original market point I was making is that the costs of hedging out the currency exposure in dollar-denominated assets has increased more than the yields on those assets have, and this has been an underappreciated force that has been weighing on the US bond market.